When Hypotheses Are Worth Trillions

UK banking regulators and the representatives of major banks intensified their discussions on new and more rigid regulatory scheme concerning the setting and calculating the British Bankers Association's London InterBank Offered Rate (BBALIBOR).

Libor, sponsored by the British Bankers Association, is the rate set for the inter-bank borrowing and lending transactions worth £220 trillion of securities a day and is produced for ten currencies with 15 maturities quoted for each currency - ranging from overnight to 12 months - thus producing 150 rates each business day.

It is also a benchmark rate indicating the average rate at which a bank can obtain unsecured funding in the London interbank market for a given period. In case the Libor figures were not available for the day, a huge portion of the global financial system would become paralysed causing havoc on the markets.

Massive and sophisticated back-up systems only proves the fact. In case of something like a terrorist attack or a natural disaster happens in London's City, dedicated phone lines are directly plugged to the homes of the rate coordinators so they can work out of office. Also, a similarly equipped office with direct phone lines and internet access is located about 150 miles out of London which is prepared to be used in case of emergency.

Despite the Libor rates being the essential part of the financial markets, flaws and illicit manipulation undermined its precision and credibility. The reasons that led the British regulators and Treasury officials to set about and investigate the flaws and manipulations with Libor rates, are the recent allegations that traders from top global banks have been consciously manipulating their bank's rates with the aim of rate abuse and the subsequent crooked financial operations worth billions.

So far, dozens of traders have been suspended and accused of deliberately manipulating the rate submissions.

Bankers from major global banks based in London, Tokyo, Singapore or New York are thought to have influenced the movement of Libor rates in order to profit from such skewed and illicit information. According to the reports, Deutsche Bank, JPMorgan Chase, RBS and Citigroup are among the banks whose traders have been suspended, based on the same convictions.

The representatives of the British Bankers' Association (BBA), Bank of England, representatives of the contributing banks and the Treasury officials met in London earlier in March to begin a review process in order to rethink the ways and methods of the interbank rate calculations and supervision of the whole process.

Financiers and regulators from the City of London will revise the ways those rates are set and will consider in their review new regulatory changes regarding the imposition of new and strict global bank liquidity requirements planned to enter into force in 2015.

These new liquidity requirements should also prevent the banks from manipulating the Libor rates in cases when banks consciously low-ball the interbank rates in order not stir up the attention of investors who might think the bank in question is having liquidity problems due to higher borrowing rates.

The most questionable part about setting this omnipotent and fundamental rate, deeply embedded in financial markets, is the way the information is received and then processed into actual output figures. The thing is that the rates submissions are very vulnerable to manipulation as the numbers submitted by the bankers are difficult to control. British Bankers' Association is forced by the bankers and regulators to step up the process to upgrade the old and awkward way of setting the inter-bank rates.

Every morning before 11:00am, the participating banks send their hypothetical borrowing rate estimates to Thomson Reuters. Reuters, being the designated calculation agent for BBALIBOR, then calculates the overall rates using its official interbank rates trimming algorithm and sends out the final output to their clients.

Now for the funniest part of the process. The banks' submissions are based on one question: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11:00am?”

When a bank is asked such a hypothetical question (which is an officially defined question by the BBA), especially in times of banks' poor liquidity during financial crisis, then the answer that follows logically offers more or less “creative” and skewed information, which the traders tend to exploit in order not to hurt the particular bank, or otherwise manipulate their submissions in order to profit from derivatives business tied into such types of rates.

Interbank rates are a fundamental cog in the whole financial markets wheel worth trillions of British pounds and it should therefore be of an utmost importance to the UK's financial services, Treasury officials and, most importantly, regulators to have reliable and correct systems available.